The Heritage Foundation

WebMemo #263 on Taxes

April 18, 2003

April 18, 2003 | WebMemo on Taxes

Understanding Pro-Growth Tax Policy

The House and Senate have chosen to provide no more than $550 billion of tax relief over the next ten years, and it is possible that the actual level of tax cuts could fall as low as $350 billion. This undermines the President's goal of boosting economic growth and job creation, but the damage can be minimized if lawmakers focus on tax reforms that improve incentives to engage in productive behavior.

Not all tax cuts are created equal. Providing a $500 annual "rebate" to every taxpayer in the country, for instance, would involve a significant reduction in tax revenue, but it would have no impact on economic growth. Eliminating - or even reducing - the double-tax on dividends, by contrast, would encourage more investment and boost the economy's performance - even though the amount of tax relief might be small compared to a universal tax rebate. It is even possible to use tax policy to boost growth without lowering the overall tax burden. A revenue-neutral flat tax, for instance, significantly would increase national economic output even though taxpayers - as a group - have no extra money in their pockets.

This is why a change in tax policy can be even more important than the size of a tax cut. With this in mind, lawmakers still have an opportunity to put together a tax plan that will boost the economy's performance even though the overall growth package will be smaller than the President requested. But this means that it is especially important to focus on policies that improve incentives to work, save, and invest. Key criteria include:

  • Will the provision lower the tax rate on productive behavior? To encourage growth, a tax cut should reduce the tax rate on work, saving, investment, risk-taking, or entrepreneurship. These are the activities that increase national income. As a general rule, credits, deductions, preferences, and exemptions do not help the economy grow faster.
  • Will the provision make America more competitive in the global economy? It is increasingly easy for jobs and capital to migrate from high-tax jurisdictions to low-tax jurisdictions. The process, known as tax competition, enhances the rewards for nations that implement pro-growth tax policy.
  • Will the provision encourage job creation? Companies do not hire workers because they feel sorry for them or because they have a social conscience. They hire workers in the expectation of making a profit. High tax rates increase the cost of labor and discourage the capital formation that is necessary to boost worker productivity.
  • Will the provision reduce the tax bias against saving and investment? Because of the capital gains tax, the corporate income tax, the personal income tax, and the death tax, the internal revenue code imposes as many as four layers of tax on income that is saved and invested. Reducing or eliminating any of these extra layers of tax will boost capital formation by creating a level playing field between current consumption and future consumption.
  • Will the provision bring the internal revenue code closer to a flat tax? This lone question actually is another way of answering the previous questions. If a provision shifts the tax code closer to a system that taxes income only one time and imposes just one low rate (with no special favors), it will benefit the economy.


Lower Tax Rates International
Competitive-ness
Pro-Job Creation Encourage Investment
Repeal the Double-tax on dividends Yes Yes Yes Yes
Accelerate lower income tax rates Yes Yes Yes Yes
Small business expensing Yes Yes Yes Yes
Accelerate child credit No No No No
Accelerate marriage penalty relief No No No No


Economic growth occurs when people work more, save more, and invest more. These are the behaviors that increase national income and boost the nation's wealth. But not all tax cuts improve incentives to engage in productive behavior. With the total amount of tax relief limited, lawmakers will have to be very selective if they intend to encourage additional economic growth.

This does not mean that other tax cuts are misguided. Under a flat tax, for instance, there is a very generous exemption for families and no marriage penalty. As such, there are elements of the President's tax package that are fully consistent with tax reform. In the interest of accurate analysis, however, those policies should be pursued for reasons other than boosting economic growth.

Last but not least, it is worth noting that the actual reduction in tax revenue associated with good tax policy always is smaller than the projections produced by static revenue-estimation models. This is because lower tax rates encourage taxpayers to work more, save more, and invest more. As a result, national income increases, which means that the tax base is concomitantly larger. This does not mean that all "tax cuts pay for themselves." Only in select instances - such as the 1997 capital gains tax rate reduction - will a tax rate reduction generate a big enough increase in taxable income to offset the revenue loss associated with a lower tax rate.

Daniel J. Mitchell, Ph.D., is McKenna Senior Research Fellow in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.

About the Author

Daniel J. Mitchell, Ph.D. McKenna Senior Fellow in Political Economy